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Think Before You Calculate

Advanced producers depend on illustrations and financial models when helping high-net-worth clients evaluate their life insurance and investment needs. But common mistakes during the modeling process can mislead clients and expose advisors to liability.

The illustrations and models often show internal rate of return (IRR) and pretax equivalent yield calculations, but advisors sometimes throw in shorthand calculations that can produce inaccurate results. The key is understanding the asset types, the ownership structures, and their corresponding income and estate tax treatment for an accurate comparison of life insurance and other investments.

For example, if the asset is owned by an irrevocable trust, it is also important to understand the gift tax implications. For 2009, the first $13,000 gifted to any person (other than gifts of future interests in property) is excluded from the total amount of taxable gifts made during that year. A married couple with two children can cumulatively give up to $52,000 ($26,000 per beneficiary) per year without incurring a gift tax. We will look at four strategies involving a case study.

The Case

A high-net-worth couple (ages 51 and 48) decide to designate $50,026 per year, with the goal of providing $10 million ($5 million each) after income and estate taxes to their two children at death. They are in good health with a joint life expectancy of 45 years. If they survive to life expectancy, they will give a total of $2,251,170 (45 payments of $50,026) over this period. Since they have two beneficiaries and can split gifts, the annual gifts should avoid gift taxes. The couple have already used their lifetime gift tax exemption and expect these assets designated for transfer to be subject to the full estate tax if owned inside the estate.

Their goals can be accomplished in several ways, each with different income and estate tax implications and long-term economic results. The ideal method for transferring assets will likely depend on the type of asset and the current ownership structure.

OPTION A Set up a joint securities trading account with a financial institution and designate each child as a 50 percent beneficiary. The couple will contribute the $50,026 to the account on the first of each year.

Results: At death, the account assets will avoid probate and receive a step-up in basis for income tax purposes. The step-up in basis at death makes it possible for heirs to inherit the property and sell it immediately with no income tax on the unrealized appreciation before death. Therefore, the unrealized earnings on appreciating assets are effectively free of income tax (if held until death). Before death, gains from dividends and account reallocations may be subject to capital gains taxation if held over a year. The same may be true for ordinary income if held for a shorter period. Maximum capital gain tax rates are 15 percent, while ordinary federal income tax rates go as high as 35 percent.

Depending on the asset, realized gains can be minimized and the income tax liability on the asset appreciation can be deferred if appropriately managed, and may be avoided if held until death. However, estate taxes up to 45 percent are still due on the total asset value at death. The account must have a value at death of $18,181,818 to net $10 million to the children after the 45 percent tax. Assuming realized gains are avoided during life and the assets receive the step-up in basis at death, the account must yield 7.56 percent per year to produce the $18,181,818 account value in year 45.

OPTION B Contribute $50,026 annually to a NQ deferred annuity and designate each child as a 50 percent beneficiary.

Results: Nonqualified deferred annuities are income in respect of decedent (IRD) assets. IRD assets generate ordinary income that would have been taxable to the decedent if it had been received by the decedent. Therefore, IRD assets have income and estate tax implications. For many people, IRD assets make up a significant percentage of their net worth. IRD assets avoid probate but are poor vehicles for passing wealth on to heirs. Many IRD assets use pretax contributions, making the whole account balance at death subject to income taxes and estate taxes.

NQ deferred annuities use after-tax contributions, making the account balance at death subject to income taxes on the inherent gains only and estate taxes on the whole account balance. This double taxation is somewhat mitigated with an IRD deduction for coordination of taxes. Assuming a 35 percent income tax rate and 45 percent estate tax rate (61 percent effective tax rate), the required accumulation value to net $10 million to the children is $25,768,085. The assets will need to earn 8.66 percent per year to generate a $25,768,085 balance in year 45.

OPTION C Set up an irrevocable trust and make the annual contributions to the trust. A trustee should be designated and the children listed as the trust beneficiaries. When each contribution to the trust is made, a Crummey letter should be sent to the trust beneficiaries to qualify the transactions as completed gifts for gift tax purposes and to avoid inclusion in the estate of the grantor parents. The trustee will allocate the contributions to an investment account.

Results: The trust agreement will usually dictate the timing of the trust distributions instead of the death of the grantors/insureds being the resolution event. Earnings and dividends will be subject to tax at ordinary income or capital gains tax rates. Estate taxes are avoided since these assets are owned outside of the grantor's estate and there are no incidents of ownership.

Using the same 45-year time horizon, the pretax equivalent yield results will be dependent on how tax-efficiently the assets were managed and the ultimate marginal tax rate. Tax will be due at some point in the future even if all earnings are deferred until the year of liquidation. If taxes are deferred long enough, the impact of taxation is almost completely mitigated. If all earnings are deferred for the 45 years and subject entirely to capital gains at 15 percent tax rates, the required accumulation value is $11,367,441. The pretax equivalent yield required is 6.03 percent.

The worst-case scenario occurs if all gains are realized and taxable as ordinary income at 35 percent each year. This creates a much different result of 8.61 percent pretax equivalent yield. The actual comparable results will be somewhere between the 6.03 percent and the 8.61 percent figures but probably closer to the 6.03 percent pre-tax equivalent yield if effectively tax managed.

OPTION D Similar to Option C above, except the trustee will purchase survivorship life insurance on the grantors and use the trust contributions to pay an annual premium of $50,026.

Results: Life insurance receives favorable tax treatment when compared to many other asset classes. One of the advantages of life insurance is that there is no current income taxation on earnings within the policy and the death proceeds are received income tax free if held until death. The second major advantage is the avoidance of estate taxes on the life insurance proceeds if the policy is owned outside the estate and there are no incidents of ownership. From a planning perspective, the trust-owned life insurance strategy is usually the desired solution if the IRRs on the insurance are attractive because the other options require a higher rate of return.

In addition, life insurance strategies provide enhanced returns in the event of early deaths that other investment strategies cannot provide, while also providing good longterm stable returns if the insureds live to life expectancy. At preferred nontobacco rates, a $50,026 annual premium can purchase a $10 million level DB policy that has an IRR at life expectancy of 5.60 percent. The major pitfall with the trust-owned life insurance solution is that there are limitations on how much money can be transferred to an ILIT each year without gift tax due to annual exclusion and lifetime gifts limitations. Many planners and attorneys try to avoid paying gift taxes on additional assets transferred to trusts. Therefore, once the annual exclusion gifts are maxed out, the question is how to address any additional wealth transfer shortfalls.

The comparable pretax equivalent yield of a trust-owned life insurance policy where 45 percent gift taxes are due on gifts is 6.83 percent in year 45. Therefore, much of the value of the trust-owned life insurance over the other alternatives is diminished by the payment of gift taxes. Alternatively, if the insurance is owned inside the estate, the couple's goals will not be met, because 45 percent of the value will be lost to estate taxes. Unfortunately, estate-owned life insurance has no tax advantage over Option A because poor financial planning or no planning can cause the loss of the estate tax exclusion benefit normally available.

Pretax equivalent yield calculations are relevant when comparing life insurance to other investments, because they can take into consideration the different income and estate tax treatment of various asset types and ownership arrangements. However, these calculations can be complicated and results misconstrued if care is not taken in conducting the analysis.

Common Mistakes

These calculations are often performed shorthand and can provide misleading results. For example, many insurance professionals incorrectly calculate the pretax equivalent yield by dividing (1) the IRR of the life insurance by (2) one minus the tax rate (income tax, estate tax or combined rate) in order to get the required return on the alternate investment. This calculation assumes taxes are imposed every year instead of deferred until death. This incorrect pretax equivalent yield calculation gets a result of 8.61 percent (calculation: 5.60% / (1 - 35%) = 8.61%). The calculation should be made by dividing (1) the insurance death proceeds by (2) one minus the tax rate to get the required pretax accumulation value of the alternative investment. Then the IRR can be calculated to show the true required compounded equivalent rate of return. To do otherwise is to falsely assume that the alternative investment is generating a tax liability every year, when the taxes may be deferred until death.

Some industry professionals exacerbate the inaccurate calculations when both income and estate taxes apply. If the income tax rate is 35 percent and the estate tax rate is 45 percent, some industry professionals show a pretax equivalent yield of 15.65 percent. They take the 8.61 percent pretax equivalent yield above and divide this number by one minus the estate tax rate. The pretax equivalent rates for the options described in the four options are significantly below these amounts. By showing pretax equivalent rates this high, the agent is inaccurately skewing the results in favor of the life insurance solution.

When working with existing and prospective life insurance clients, it is important to understand the tax treatments of various asset classes during a lifetime and upon death to ensure an optimal transfer of wealth to heirs. This will allow the advisor to show various financial alternatives correctly so the client can make an informed financial decision. Otherwise, advisors may subject themselves to potential liability if decisions are based on unsound economic projections due to incorrect tax and timing assumptions and their signifi- cant impact on assumed internal rate of return and pretax equivalent yield results.

Kenneth W. Godfrey, CLU, ChFC, CFP, has more than 12 years in the life insurance industry specializing in the areas of advanced case design, implementation, administration and funding evaluation of both wealth transfer and nonqualified executive benefit p [email protected].

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